FX Traders Weary of Unfinished Business in Washington?

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Daily FX Market Roundup 01-02-13

FX Traders Worried About Unfinished Business in Washington?
EUR: Correlation with US Stocks Break Down
GBP: Shrugs Off Sharp Improvement in PMI
AUD: Supported by Upward Revision to PMI
NZD: Comm Dollars Lifted by Risk Appetite
CAD: Oil and Gold Prices Up Another 1%
USD/JPY Hits Fresh 2 Year Lows

FX Traders Worried About Unfinished Business in Washington?

While equity traders welcomed Washington’s Fiscal Cliff deal, the price action in the foreign exchange market today suggests that Forex traders are growing worried about unfinished business in Washington. All of the major currencies ended the day well off their highs against the dollar with the EUR and GBP ending the day lower. In fact, the EUR/USD even dropped to a 2 week low as the initial enthusiasm in the market begins to fade. Commodity currencies held onto most of their gains but have receded from earlier highs. It will be interesting to see whether the optimism of equity traders or the caution of currency traders win out.

The problem is that there’s a lot of unfinished business in Washington. Spending cuts still need to be negotiated along with additional tax reform and an increase to the debt ceiling. As quickly as they have penned the Fiscal Cliff deal, Congress will need to start negotiating a higher debt ceiling. The drama hasn’t ended because Republicans won’t readily agree to a higher debt limit without offsetting spending cuts, which the Democrats oppose. Some investors are also worried about the impact of the payroll tax hike on Americans. For someone making $50,000 a year, payroll taxes are expected to increase by $1,000. We don’t think the impact on spending will be too significant because the Fiscal Cliff deal should encourage U.S. corporations to start spending again and provide underlying support to the economy. What we are more worried about is the psychological impact of a possible U.S. credit rating downgrade. Back in September, rating agency Moody’s threatened to downgrade the U.S. if it goes over the cliff. While a deal has been reached, it is not as ambitious as many had hoped which means Moody’s could still move forward with a downgrade. Considering that S&P already stripped the U.S. of its AAA rating, it won’t be a stretch for Moody’s to follow suit but if they were to do so, it could be psychologically damaging enough to drive investors back into safe have currencies.

Meanwhile it is time to start thinking about the U.S. payrolls report. A number of the leading indicators for NFPs that we typically followed will be released tomorrow including the ADP report, Challenger Job cuts and jobless claims. Overall, we expect these reports to show continued improvements in the labor market particularly since jobless claims in December have been on average lower than November. This morning’s U.S. economic reports were mixed with manufacturing activity rising from a 3 year low in the month of December. The ISM index rose to 50.7 last month compared a prior reading of 49.5. The sector is expanding once again thanks to higher prices paid, order backlog, supplier deliveries, customer inventories, new export orders, imports and employment. Construction spending dropped 0.3% in November, but the overall improvement in manufacturing activity paints a brighter outlook for the U.S. economy.

EUR: Correlation with US Stocks Break Down

Once again, the euro failed to participate in the risk rally despite the strong rise in European stocks and bonds. The German DAX climbed to its highest level in nearly 5 years while 10 year Spanish bond yields dropped below 5% for the first time since March. While bond yields of countries at risk of default have fallen, yields of stronger nations such as Germany and France have risen. This dynamic confirms that sovereign stress in the region is easing and investors are returning to Eurozone assets. Yet many investors are confused about why the EUR/USD refuses to participate in the rally. There’s talk that investors are actually more worried about the outlook for Europe than the price action suggests. Some say that the EUR/USD was artificially propped up at year end by repatriation flows to shore balance sheets and now those funds are moving outwards again. We find this argument a bit hard to believe since German bonds have performed well and the European markets are up more than 2% today. Nonetheless, the breakdown in the correlation between the EUR/USD and U.S. stocks is important enough for us to monitor closely. This morning’s Eurozone economic reports were mixed. German consumer prices increased in December but manufacturing activity was revised down, causing the region’s overall PMI index to be revised lower as well. German unemployment numbers are due for release on Thursday. According to the PMI report, job losses were reported in the manufacturing sector for the third month in a row. While the pace was modest, it was still worse than the previous month. The service sector on the other hand saw a modest increase in staffing levels, which should offset the loss in manufacturing and explains why economists are looking for only a small increase.

GBP: Shrugs Off Sharp Improvement in PMI

It has been a volatile day for the British pound, which rose to a one year high against the U.S. dollar at the start of Asian trading session, only to give up those gains and end the day unchanged against the greenback. Stronger than expected manufacturing activity had very little impact on sterling. While the PMI manufacturing index rose to its highest level in 15 months and exceeded the 50 boom / bust mark for the first time in 8 months, GBP/USD traders appeared to be completely unfazed as the release yielded no more than a 20 pip rally in the currency pair. Less than a half an hour later, the currency pair had already given up those gains. Unfortunately there is very little to explain the reversal outside of concern shifting to U.K. fiscal finances. Nationwide house prices are due for release tomorrow along with PMI Construction. House prices are expected to remain flat and construction activity is expected to improve slightly. The data will most likely confirm that so far, the stimulus provided by the government’s Funding for Lending Scheme has been limited.

AUD: Supported by Upward Revision to PMI

The improvement in risk appetite and rise in commodity prices drove the Australian, New Zealand and Canadian dollars sharply higher against the greenback today. For once, the AUD is the best performing currency with AUD/NZD erasing its earlier losses and powering higher. Better than expected Australian economic data lent support to the currency with manufacturing activity holding steady in December but revised higher in November. While manufacturing conditions continue to contract in Australia, the upward revision was a welcomed improvement. The RBA’s commodity price index also ticked upwards. Chinese manufacturing PMI numbers were released over the holiday. While HSBC found manufacturing activity accelerating at the end of the year, the government’s official release reported steady activity. According to the National Bureau of Statistics, the manufacturing PMI index remained unchanged at 50.6. As long as the index remains above 50, the sector is still expanding but the Chinese government has taken deliberate effort to set expectations for steady but moderating growth in 2013. Nonetheless, AUD/USD and the other commodity currencies have taken the news in stride, choosing instead to focus on positive U.S. news. No economic reports are expected from the commodity producing countries tomorrow but Chinese non-manufacturing PMI numbers are scheduled tonight along with Fonterra Milk Power Auction results on Thursday. As a major dairy producer, milk auction results can be important to the NZD.

USD/JPY Hits Fresh 2 Year Lows

Japanese markets were closed overnight but that did not stop the Yen from falling to fresh multi-year lows against many major currencies. The Japanese Yen dropped to its lowest level against the U.S. dollar since July 2010 and its lowest against the euro since August 2011. More significant milestones were reached against other major currencies with the decline against the commodity currencies being the most significant. The Yen dropped to its lowest level against the AUD and NZD in more than 4 years. The downtrend in the Japanese Yen is strong and there is very little reason to believe that it will stop anytime soon. In just under 3 weeks, the Bank of Japan is expected to increase its inflation target and with the risk in the FX markets eased by the U.S. Fiscal Cliff deal, USD/JPY could continue to trend higher in anticipation of more aggressive monetary policy from the BoJ. According to the most recent CFTC IMM numbers, speculators cut their long USD/JPY positions last week (most likely ahead of year end) and some of those traders may not want to reinitiate those positions. No major Japanese economic reports are due for release this evening but that does not mean that the focus will be off the Yen.

Kathy Lien
Managing Director

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